What is Finance
Finance describes the flow of money and how people, companies, and governments make, save, invest, borrow, and spend it.
Personal finance is about budgeting, spending, borrowing, saving, and investing for the future. Corporate finance involves raising capital and issuing stock. establishing and expanding a business, purchasing equipment, leasing machinery, and hiring staff.
Public finance focuses on managing public debt, spending on public services, collecting taxes, and stimulating the economy. Finance is critical to growing wealth, making decisions, and managing risk.
How Finance Works
Finance is typically broken down into three broad categories: Public finance, Corporate finance, and Personal finance.
Public finance includes tax systems, government expenditures, budget procedures, stabilization policies and instruments, debt issues, and other government concerns.
Corporate finance involves managing assets, liabilities, revenues, and debts for businesses.
Key Finance Terms
Asset: An asset is something of value, such as cash, real estate, or property. A business may have current assets or fixed assets.
Balance sheet: A balance sheet is a document that shows a company’s assets and liabilities. Subtract the liabilities from the assets to find the firm’s net worth. Cash flow: Cash flow is the movement of money into and out of a business or household. Compound interest: Compound interest is calculated and added periodically, unlike simple interest, which is interest added to the principal only time. This results in interest being charged not only on the principal but also on the interest that's already accrued.
Equity: Equity means ownership. Stocks are called equities because each share represents a portion of ownership in the underlying corporation or entity. Liability: A liability is a financial obligation, such as debt. Liabilities can be current or long-term. Liquidity: Liquidity refers to how easily an asset can be converted to cash. Real estate isn't a very liquid investment because it can take weeks, months, or even longer to sell. Profit: Profit is the money that's left over after expenses. A profit and loss statement shows how much a business has earned or lost for a particular period.
Types of Finance
Public Finance
The federal government helps prevent market failure by overseeing the allocation of resources, distribution of income, and stabilization of the economy. Regular funding for these programs is secured mostly through taxation.16
Borrowing from banks, insurance companies, and other governments and earning dividends from its companies also helps finance the federal government.
State and local governments receive grants and aid from the federal government. Other sources of public finance include:
- User charges from ports, airport services, and other facilities
- Fines resulting from breaking laws
- Revenues from licenses and fees, such as for driving
- Sales of government securities and bond issues
Corporate Finance
Businesses obtain financing through a variety of means from equity investments to credit arrangements. A firm might take out a loan from a bank or arrange for a line of credit. Acquiring and managing debt properly can help a company expand and become more profitable.
Startups may receive capital from angel investors or venture capitalists in exchange for a percentage of ownership. A company will issue shares on a stock exchange if it thrives and goes public. Such initial public offerings (IPOs) bring a great influx of cash into a firm. Established companies may sell additional shares or issue corporate bonds to raise money.
Businesses might also purchase dividend-paying stocks, blue-chip bonds, or interest-bearing bank certificates of deposit (CDs). They may buy other companies in an effort to boost revenue.
Personal Finance
Personal financial planning generally involves analyzing an individual’s or a family’s current financial position, predicting short- and long-term needs, and executing a plan to fulfill those needs within individual financial constraints. Personal finance depends largely on one’s earnings, living requirements, and goals and desires.
Matters of personal finance include but aren't limited to the securing of financial products like credit cards, life and home insurance, mortgages, and retirement products. Personal banking products such as checking and savings accounts, individual retirement accounts (IRAs and 401(k) plans) are also considered a part of personal finance.
The most important aspects of personal finance include:
- Assessing the current financial status, such as expected cash flow and current savings
- Buying insurance to protect against risk and to ensure that one’s material standing is secure
- Calculating and filing taxes
- Earmarking savings and investments
- Planning for retirement
Personal finance is a specialized field, although forms of it have been taught in universities and schools as “home economics” or “consumer economics” since the early 20th century.
The field was initially disregarded by male economists because “home economics” appeared to be the purview of housewives. Economists have repeatedly stressed widespread education in matters of personal finance as integral to the macro performance of the overall national economy.
Social Finance
Social finance typically refers to investments made in social enterprises, including charitable organizations and some cooperatives. These investments take the form of equity or debt financing in which the investor seeks both a financial reward and a social gain.
Forms of social finance also include some segments of microfinance, specifically loans to small business owners and entrepreneurs in less-developed countries to enable their enterprises to grow. Lenders earn a return on their loans while simultaneously helping to improve individuals’ standards of living and to benefit the local society and economy.
Social impact bonds, also known as Pay for Success Bonds or social benefit bonds, are a specific type of instrument that acts as a contract with the public sector or local government. Repayment and return on investment are contingent upon the achievement of certain social outcomes and achievements.
Behavioral Finance
There was a time when theoretical and empirical evidence seemed to suggest that conventional financial theories were reasonably successful at predicting and explaining certain types of economic events.
Academics in the financial and economic realms, nonetheless, detected anomalies and behaviors that occurred in the real world but couldn't be explained by any available theories.
It became increasingly clear that conventional theories could explain certain “idealized” events, but the real world was a great deal messier and more disorganized. Market participants frequently behave in ways that are irrational and difficult to predict according to those models.
Academics began to turn to cognitive psychology to account for irrational and illogical behaviors that can't be explained by modern financial theory. The field of behavioral science was born out of these efforts. It seeks to explain our actions whereas modern finance looks to explain the actions of the idealized “economic man (Homo economicus).”
Behavioral finance is a subfield of behavioral economics. It proposes psychology-based theories to explain financial anomalies such as severe rises or falls in stock prices. The purpose is to identify and understand why people make certain financial choices.
It's assumed within behavioral finance that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.
Daniel Kahneman and Amos Tversky began to collaborate in the late 1960s and are considered by many to be the fathers of behavioral finance. Richard Thaler joined them later and combined economics and finance with elements of psychology to develop concepts like mental accounting, the endowment effect, and other biases that have an impact on people’s behavior.
What is 7% Rule in Finance
The “7% rule” suggests retirees can withdraw 7% of their retirement savings annually without running out of money. Long-term historical data do not back this figure. It’s considered aggressive and risky, especially for those expecting a 20–30+ year retirement.
The assumption behind this rule is that your investments will earn at least 7% net of inflation every year and that you’ll maintain stable expenses, market conditions, and life expectancy. In reality, market volatility, inflation, taxes, and healthcare costs make this strategy unreliable for most people.
How It Works: You take 7% of your portfolio value in year one, and each year thereafter you adjust for inflation.
Why It’s Unique: It assumes your investments continue growing aggressively even as you withdraw.
Pros:
- Higher income early in retirement.
- May allow for a better lifestyle.
Cons:
- Highly vulnerable to stock market crashes or underperformance.
- Much greater risk of depleting savings too soon.
- This withdrawal rule can apply to several retirement accounts, including:
- Thrift Savings Plan
- Profit Sharing Plan
- Cash Savings
What are the 5p of Finance
Asset management is a critical field that involves overseeing and managing investments, such as real property investments, to achieve specific financial goals. The success of asset management relies heavily on the effective integration of five essential elements: Planning, People, Process, Portfolio, and Performance. Together, these components create a framework for ensuring that investments are managed optimally to generate maximum returns.
Planning: Planning is the cornerstone of asset management. It begins with defining investment objectives, setting clear goals, and developing a strategy to achieve them. This could involve determining risk tolerance, time horizon, and asset allocation. Effective planning helps investors align their investments with their long-term objectives, providing a roadmap for making informed decisions.
People: The people behind the asset management process play a crucial role in driving success. For real property, this includes real estate professionals who bring expertise, experience, and decision-making skills to the table. Their insights and judgment are essential in navigating market fluctuations, identifying investment opportunities, and managing risks. A strong, well-informed team ensures that assets are managed with precision and insight.
Process: The process refers to the structured methods and practices that asset managers use to implement their strategies. This includes everything from research and analysis to risk management and compliance. A well-defined process helps ensure consistency in decision-making, transparency, and accountability, all of which are vital for maintaining investor trust and optimizing portfolio performance.
Portfolio: The portfolio represents the collection of investments managed to achieve the investor’s objectives. A balanced and diversified portfolio can help mitigate risks while enhancing the potential for returns. The portfolio should be regularly reviewed and adjusted based on market conditions, changes in the investor’s goals, and evolving economic factors. A thoughtful, strategic approach to portfolio management is key to long-term success.
Performance: Performance is the ultimate measure of success in asset management. Regularly assessing performance against benchmarks and goals is essential to ensure that investments are on track. By analyzing performance, investors can identify strengths, weaknesses, and areas for improvement, enabling them to refine their strategies and make adjustments where necessary.
Together, these five P’s create a cohesive framework that drives successful asset management. By focusing on planning, people, process, portfolio, and performance, investors can maximize their chances of achieving financial success while effectively managing risks.